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Despite a rally in the broader S&P 500 index in 2023, which is up slightly more than 14%, smaller stocks with more expansive breath are seeing muted returns. The Russel 2000, which captures a group of smaller stocks, is slightly higher for the year, rising about 5%. Equity indices are made up of the haves and the have-nots. The same can be said for the forex markets and the commodity markets. While some large-cap technology shares are experiencing robust returns, several sectors face significant headwinds and have had little traction during 2023. While the S&P 500 index shows double-digit returns, the equal-weight S&P 500 index is barely higher. While the Russel 2000 is up 5%, the equal-weight Russel 2000 is lower in 2023. Rising interest rates, the continued war in the Black Sea, and the fear of a global recession are weighing on specific sectors. Here are the five things hurting market productivity in 2023.
The Haves and Have Nots
Before discussing the different factors impacting specific sectors of the markets, it is essential to understand why particular indices are rising while others are not.
One of the more popular indices is the S&P 500 index. The S&P 500 index is a market-capitalization-weighted index of the 500 largest publicly traded companies in the U.S. The index is calculated by taking the sum of the market capitalization of each 500 companies and dividing it by a divisor. The divisor is adjusted to account for corporate actions such as stock splits and mergers. The index is updated daily and is widely used as a benchmark for the U.S. stock market. The S&P 500 is generally considered the benchmark for United States equity markets. One of the issues with this index is its calculation depends on market capitalization, which means that the most extensive capitalization stocks have the most influence when it comes to impacting the direction of the broader market index.
An alternative index is the S&P 500 equal weight index. The Equal Weight S&P 500 Index is calculated by assigning equal weight to each of the 500 stocks in the S&P 500 Index. This calculation means that each stock in the index is given an equal weight of 0.2%. The index is then calculated by taking the sum of the prices of each of the 500 stocks and dividing it by the total number of stocks in the index. The resulting figure is the index value. The index is rebalanced quarterly to ensure that each stock remains at its equal weight.
The upshot is that an equal weight index is an index that assigns a similar weight to each component of the index, regardless of the size of the company. This type of index is designed to reduce the influence of large companies on the index and provide a more balanced representation of the market. The Russell 2000 is also calculated as a market capitalization index, while the equal weight Russel 2000 is calculated similarly to the S&P 500 equal weight index.
Equity markets are seeing a divergence in the direction of some of the different constituents, and part of the divergence is the company’s size. Small stocks are typically more volatile than large stocks and are more sensitive to economic downturns. During economic uncertainty, investors tend to flock to large stocks, which are considered safer investments. Large stocks also tend to have more liquidity, which makes them more attractive to investors. On the other hand, small stocks may not have the same level of liquidity and may be more susceptible to market fluctuations. As a result, large stocks are more likely to rally during economic uncertainty, while small stocks may not.
Without the top 20 stocks in the S&P 500 index, the broader market could be lower in 2023. The stocks that seem to drive the rally in the large-cap index are associated with artificial intelligence.
Why is There a Divergence in Equities
The theme behind the rally in the broader large-cap S&P 500 likey centers around security and the demand for stocks that are involved in artificial intelligence. Some large-cap stocks include Microsoft, Alphabet, Nvidia, and Apple. The large-cap tech companies have helped drive the S&P 500 index higher.
What is Generating Headwinds for Most Stocks
One of the factors that are generating headwinds for stocks and helping to drive the U.S. dollar in forex trading is higher U.S. borrowing rates. The Federal Reserve, the central bank in the United States, has lifted short-term borrowing rates by more than 5.25% in the past 18 months. The Fed is focusing on one of its dual mandates: price stability and maximum employment. According to the U.S. Commerce Department, the Consumer Price Index in the United States increased by 4% year over year in May, which is still well above the Fed’s target of 2%.
Since short-term borrowing rates impact stock prices and the dollar, it would make sense that some capital markets’ financial instruments would be affected by the rapid rise in U.S. rates. Interest rates generally impact equity prices since their values are somewhat based on discounted cash flows.
Discounted cash flow is a method of valuing a project, company, or asset using the time value of money. It is used to estimate the attractiveness of an investment opportunity by discounting the expected cash flows to present value. For example, if you expect to receive $100 in a year, and the current one-year interest rate is 5%, the value of your money is worth the future value of $100 multiplied 100% minus the current interest rate (100% – 5%) or 95%. That would mean $100 in one year is worth $95 today.
The dollar is impacted by higher rates as higher short-term borrowing in the United States makes the dollar more attractive relative to other currencies. As yields rise in the United States relative to another country, the cost of shorting the dollar becomes more onerous, and the benefit of holding on to a higher-yielding currency becomes more attractive.
For example, the Yen overnight interest rates have remained below zero for the past 18 months, while the United States has increased rates during the same period. As the interest rate differential between the dollar’s short-term borrowing rate and the Yen short-term borrowing rate moved in favor of the dollar, it became more difficult for those who wanted to be long Yen to hold on to positions. If you had a long Yen position during this period, excluding the spot rate change, you would need to pay away above 5% due to the interest rate charge.
Another factor that has generated headwinds for specific stocks and currencies is the concern of a global recession. If growth declines to zero or even negative, it will be hard for stocks to generate tailwinds and rally significantly. Investors wanting to invest in equities are likely to invest in large-cap stocks that will be more defensive than smaller ones.
Other factors that have created volatility for the markets are the rise and subsequent fall of many commodity prices following the breakout of the war in the Black Sea region. The war between Russia and Ukraine cause a price spike. In the aftermath of this spike was a collapse in the price of oil and natural gas along with wheat which created additional market volatility.
The Bottom Line
Several factors are generating headwinds to the markets. Stocks and currencies are seeing specific trends generated from higher rates, a swing in the interest rate differential, and lower growth. High inflation expectations have driven central banks to increase interest rates at different speeds. In Japan, the Bank of Japan has barely moved to contain inflation. As the Federal Reserve, Bank of England, and European Central Bank increased interest rates, short-term borrowing rates in their respective regions have increased related to Japan, driving up these currencies related to the yen.
At the same time, higher interest rates are stifling growth and have generated a divergence in the equity markets. While large-cap tech stocks have rallied, they have driven up the market-cap-weighted S&P 500 index, the U.S. stock benchmark. When comparing the market-cap-weighted S&P 500 index and the equal-weighted S&P 500 index, you can see that the returns on the market-cap-weighted S&P 500 index are stronger, driven by just a handful of stocks that comprise the bulk of the weightings. Higher rates and the potential for lower growth weighed on many of the stocks in the S&P 500 index. This scenario is also true for the Russel 2000, a broader measure of lower capitalization stocks, including small-cap stocks.
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